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At the end of an accounting period, a company may have in issue some securities which do not (at present) have any claim to a share of equity earnings, but may give rise to such a claim in the future. These securities include:

a) A separate class of equity shares which at present is not entitled to any dividend, but will be entitled after some future date

b) Convertible Debentures or convertible preferred shares which give their holders the right at some future date to exchange their securities for ordinary shares of the company, at a pre-determined conversion rate

c) Option or warrants

In such circumstances, the future number of ordinary shares in issue might increase. This in turn results in a fall in the EPS. In other words, a future increase in the number of ordinary shares will cause a dilution of equity, and it is possible to calculate diluted earnings per share (i.e. the EPS that would have been obtained during the financial period if the dilution had already taken place). This will indicate to investors the possible effects of a future dilution.

Earnings:

The earnings calculated for basic EPS should be adjusted by the post-tax (including deferred tax) effect of

a) Any dividends on dilutive potential ordinary shares that were deducted to arrive at earnings for basic EPS

b) Interest recognized in the period for the dilutive potential ordinary shares

c) Any other changes in income or expenses (fee and discount, premium accounted for as yield adjustments) that would result from the conversion of the dilutive potential ordinary shares

The conversion of some potential ordinary shares may lead to changes in other income or expenses. For example, the reduction of interest expense related to potential ordinary shares and the resulting increase in net profit for the period may lead to an increase in the expense relating to non-discretionary employee profit sharing plan. When calculating diluted EPS, the net profit or loss for the period is adjusted for any such consequential changes in income or expense.

Per Share:

The number of ordinary shares is the weighted average number of ordinary shares calculated for basic EPS plus the weighted average number of shares that would be issued on the conversion of all the dilutive potential ordinary shares into ordinary shares. It should be assumed that diluted ordinary shares were converted into ordinary shares at the beginning of the period or, if later, at the actual date of issue.

Solved problem # 1:

Basic EPS of a company is Rs. 1.05 per share based on earnings of Rs. 105,000 and 100,000 ordinary Re. 1 shares. It also had in issue Rs. 40,000 15% Convertible Debentures which is convertible in two years’ time at the rate of 4 ordinary shares for every Rs. 5 of debenture. The rate of tax is 30%. In 2007 gross profit of Rs. 200,000 and expenses of Rs. 50,000 were recorded, including interest payable of Rs. 6,000

Income Statement before conversion of debentures into the ordinary shares

Rupees

Gross profit 200,000 Operating expenses (44,000) Profit from operations 156,000 Financial expenses (6,000) Profit before tax 150,000 Income tax 30% (45,000) Profit after tax (earnings) 105,000

Diluted earnings per share

a) Conversion of debentures into the ordinary number of shares Rs. 40,000 x 4/5 = 32,000 number of ordinary shares

b) Adjustment of profits after the conversion of debentures into the ordinary

Rupees

Gross profit 200,000 Operating expenses (44,000) Profit from operations 156,000 Income tax 30% (46,800) Profit after tax (earnings) 109,200

d) Diluted EPS

Rs. 109,200 = Rs. 0.827 per share 132,000

e) Dilution:

The dilution in earnings would be Rs. 1.05 less 0.827 = Rs. 0.223/share.

Dilutive potential ordinary shares

Those convertible debentures or securities that will cause an increase in Basic EPS had these would have been converted in the current year are anti-dilutive potential ordinary shares. According to IAS 33, potential ordinary shares should be treated as dilutive when, and only when, their conversion to ordinary shares would decrease net profit per share from continuing operations. This point is illustrated in the following example:

Conversion rate is 3 ordinary shares will be issued against each Rs. 20 debentures in issue Rs. 40,000 x 3/20 = 6,000 number of shares

Revised Income statement after conversion

Rupees

Profit from operations 156,000 Financial charges 0 Profit before tax 156,000 Income Tax @ 30% (46,800) Profit after tax 109,200

Revised earnings per share after conversion

Rs. 109,200 = Rs. 1.030 per share 106,000shares

There is no dilution as the post conversion EPS is greater than the basic EPS.

This can also be understood by calculating individual EPS of the security/debenture. If the individual EPS of the security is lesser than the basic EPS then it is a dilutive potential shares, whereas, if the individual EPS of the security is greater than the basic EPS then it is a non dilutive potential shares.

Like is this case: Rupees

Savings of financial charges 10,000 Income tax impact @ 30% (3,000) Impact on the earnings to the extent of the security 7,000

Individual EPS Rs. 7,000 = Rs. 1.667 6,000 shares

This individual EPS is greater than the basic EPS i.e. 1.022 per share therefore this security is anti-dilutive potential share and should not be converted into the ordinary shares before calculating the diluted earnings per share.

Solved problem # 2:

Ali Imran Co has 5,000,000 ordinary shares in issue, and also had in issue in 2004:

a) Rs. 1,000,000 of 14% convertible debentures, convertible in three years’ time at the rate of 2 shares peer Rs. 10 of debentures b) Rs. 2,000,000 of 10% convertible debentures, convertible in one year’s time at the rate of 3 shares per Rs. 5 of debenture.

• The total earnings in 2004 were Rs. 1,750,000
• The rate of income tax is 35%

Requited: Calculate the basic EPS and the diluted EPS

Solution:

Basic EPS = Rs. 1,750,000 = 35 paisa 5,000,000

Diluted EPS:

Before calculating diluted EPS we must decide which of the potential ordinary shares (the convertible debentures) are dilutive.

a) Conversion into ordinary shares Rs. 1,000,000 x 2/10 = 20,000 ordinary shares

Savings of financial charges Rs. 1,000,000 x 14% 140,000 Income tax impact @ 35% (49,000) Impact on the earnings to the extent of the security 91,000

Individual EPS Rs. 91,000 = 45.5 paisa (greater than the basic EPS) 20,000

b) Conversion into ordinary shares Rs. 2,000,000 x 3/5 = 1,200,000 ordinary shares

Savings of financial charges Rs. 2,000,000 x 10% 200,000 Income tax impact @ 35% (70,000) Impact on the earnings to the extent of the security 130,000

Individual EPS Rs. 130,000 = 10.8 paisa (lesser than the basic EPS) 1,200,000

Therefore the diluted EPS will be calculated after converting the 10% debentures.

Rs. 1,750,000 + Rs. 130,000 = Rs. 1,880,000 = 30.30 paisa 5,000,000 + 1,200,000 6,200,000

Dilution is equal to

Basic EPS 35.00

Diluted EPS 30.30

Dilution 4.70